Commercial real estate has come a long way from the depths of the 2001 recession, but the journey to recovery remains at a distance, according to industry observers assessing the prospects for 2006.

“The good news is, we are seeing modest improvement, but the bad news is, it is only modest, and really is not transferring to new job growth,” said William F. McCall Jr., president of Boston-based McCall & Almy. “And until we see more jobs, it is going to remain just modest.”

Two of the area’s traditional employment engines – technology and financial services – are “dead in the water” at present, McCall said last week, adding that he believes a crush of capital chasing office buildings has been “overly aggressive” in revenue projections.

“There’s a lot of wishful thinking,” said McCall, citing recent acquisitions that are “priced for perfection,” offering little wiggle room for unforeseen capital improvements or sudden market downturns. Despite substantial vacancies and tepid movement of rental rates, Boston office buildings were a popular target for investors last year, with such assets as 31 Milk St., 18 Tremont St., 200 State St. and 99 High St. all changing hands.

Although the product pipeline had been thinned out somewhat by year’s end, the desire for office assets has seemingly not cooled as the new year begins, and several owners were being lured into the sales market as the year closed out. Given the positive net absorption enjoyed in 2005 after several negative years, plus a slight shift upward in the rental rates, Boston’s investment market should remain brisk in the coming months, maintained Trammell Crow Co. principal Joseph P. Fallon. “If anything, buyers are going to have to prioritize what they are going to look at,” said Fallon, or select a specific asset class to pursue such as industrial or retail.

Fallon also acknowledged areas of difficulty for the region, especially in outer markets such as Interstate 495, but said he was generally satisfied with the gains seen in 2005 and anticipates that will carry over into the new year. “There’s some positive momentum going forward,” said Fallon, even as an unanticipated block of 160,000 square feet became available in Marlborough through a corporate consolidation that hit the area late in the year. “The hope is that there are not more of those hiccups in 2006,” said Fallon, who opined that most of the surprise supply surpluses have worked their way through already, with the office space inventory also tightened by a lack of new construction.

In that regard, Fallon said he believes the improving office markets might actually yield a speculative office project in the coming year, most likely in the Waltham/Wellesley area that has bounced back as strongly as any submarket in the country. With rents now topping the $30 per-square-foot mark there, and a dearth of large contiguous blocks of space available, Fallon said he “wouldn’t be surprised to see a sprinkling of developers” advancing with new projects to meet a 2007 delivery date.

“Certainly build-to-suit activity will be active, especially in the high-end of the market,” said Fallon, referring to space requirements of 100,000 square feet and above that have only limited options available in the more preferred markets. The demand for space has been encouraging of late, said Fallon, particularly among companies focused on the medical field and life sciences.

‘More Velocity’
CRESA Partners President Joseph F. Sciolla also reported improved conditions. “I’m optimistic that the market is picking up,” said Sciolla, whose firm represents tenants in making real estate decisions. “There seems to be more velocity, and the business community seems to be more positive, and I think that will continue into 2006.”

Sciolla concurred with Fallon that build-to-suit will become more prevalent this year, but said he doubts speculative construction will be advanced by all but the most adventurous developers. One key concern being addressed by CRESA at present has been the increase of construction materials emanating from higher demand internationally and shortages of petroleum, which is used in the making of many such products. By CRESA’s estimates, construction costs are up as much as 30 percent, and should remain high over the near term.

As a result, tenants and landlords alike will be squeezed financially, resulting in less income for building owners and limited use of tenant improvement dollars for companies building out space. “We have to educate our clients to be prepared for that,” said Sciolla, requiring greater scrutiny of lease terms and negotiating flexibility in selecting vendors for such expenses as utilities. Rising energy costs can be offset by a special deal with a supplier, said Sciolla, but only if that is provided for in advance.

As for the office market overall, Sciolla said it continues to be a bifurcated situation, with vacancy rates for Class A office space in Boston towers now down into the 5 percent range but outmoded space largely unspoken for or abandoned for better buildings. The older inventory has been aided by the purchase of buildings for conversion to residential, said Sciolla, especially in fringe markets such as Fort Point Channel and North Station, but the flight-to-quality trend has kept vacancy rates for Class B product high, he explained.

“The Class B market has been pretty flat,” said Sciolla, predicting that any recovery there will not be seen until late in 2006 and possibly not until 2007. As with McCall, Sciolla voiced concern about the state’s unimpressive job growth, even though the state will finally have seen a gain in 2005 vs. the previous year, and most anticipate that trend will remain on the upswing in the coming months. “That has to be taken into consideration,” Sciolla said of the state’s woes in job growth.